A dose of reality for Shoppers' investors

Everybody wants to get into the pharmacy business, it seems. Target Corp. is developing a network to accompany its entry to Canada next year, while McKesson Corp. will buy a division of Edmonton's Katz Corp., owner of the Rexall chain. It seems it couldn't be a better time to be Shoppers Drug Mart Corp.

The tail side of that coin, however, is that the best times for Shoppers will soon be behind it, if they are not already – and investors should set their expectations accordingly.

Now, before you hyperventilate – and require a prescription, to be filled at Shoppers – let me make clear this isn't a strong "sell." Canadians are getting older and clearly will need more medicine. An expected pullback in Shoppers' capital spending should jack up the cash flow available to investors through dividends or buybacks.

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That type of behaviour, however, belongs to a mature company, which is what Shoppers has become after years of being a growth story. The company once consistently posted high single-digit revenue growth, with earnings per share gains that topped 15 per cent or more. When Shoppers reports full-year results on Feb. 9, the top-line gains and EPS growth are expected to be in the very low single-digit range.

As a result, Shoppers' price-to-earnings multiple has contracted. A forward P/E that regularly topped 20 before the Great Recession is now around 14. And while some analysts believe excellent execution could produce a slight multiple expansion – to 15 – an erosion in results might send it lower. (By way of comparison, Shoppers' out-of-favour U.S. counterpart, Walgreen Co., of which I own 50 shares in a retirement account, trades for around 12 times profit.)

"Shoppers Drug Mart's days as a growth stock are over, in our view," Perry Caicco of CIBC World Markets Inc. wrote after the company released third-quarter earnings in November. "The classic Canadian pharmacy model – reliant on government overpayments and generic company rebates – is pretty much dead. Across Canada, provincial health authorities are ending the lucrative game, cutting reimbursement rates and restricting the allowable payments between generic manufacturers and pharmacists."

Adds Morningstar Research analyst Matthew Coffina, who has a "fair value" estimate of $39 on Shoppers: "We think Shoppers' future could be replete with regulatory pricing pressure. We are hesitant to invest in any company whose prices the government could slash by 50 per cent or more overnight."

That means, CIBC's Mr. Caicco says, that Shoppers' future sources of growth must come from either increases in same-store sales or increased market share. While prescription counts in Canada are increasing, the growth is slowing, and the price decreases from provincial cutbacks are cutting into the top line, he says. Meanwhile, Shoppers' "front-store" sales – all that stuff you have to get by to pick up your prescription –also have been slowing. Shoppers' third-quarter 1.8-per-cent gain in same-store sales for these items was its worst number in five years, Mr. Caicco says.

"We have long been concerned about the strength and direction of Shoppers' front-store offering," Mr. Caicco says, adding that new food and beauty offerings "don't seem to push same-store sales very hard." And Shoppers "has been aggressive in taking price increases all over the front of the store; surveys we have taken of like items show regular price increases averaging about 30 per cent over the last four years."

Can Shoppers continue that tack as Wal-Mart Stores Inc. and Target house pharmacies in their stores? I wouldn't bet on it. The retailing giants have known for some time that the benefit of having pharmacies in their stores is increased foot traffic and boosted sales of the rest of their stuff – stuff that is likely to be cheaper than in the local Shoppers store.

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For now, the Canadian pharmacy model allows Shoppers (and Jean Coutu Group ) to post profit margins several percentage points above their U.S. counterparts, and allows them higher P/Es as well.

To maintain that position, Shoppers must do an awful lot of things right in the front of the store and dodge a full-scale pricing assault from provincial governments aimed at its pharmacies in the back. A handful of analysts see Shoppers executing well, rewarding its shareholders, and appreciating to $48 a share, from its current $41.50, in the coming 12 months. It seems just as easy to imagine a retreat below $40 – which would leave shareholders a little more sorry than safe.

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